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FB, Zynga Modify Agreement

Reportedly, Facebook Inc. (FB) and Zynga Inc. (ZNGA) have made several changes to their current business agreement through a regulatory filing.

According to the revised terms of the agreement, gamers would no longer be compelled to use the Facebook Payment system to buy Zynga’s in-game items. Currently, Facebook gets 30% share on all in-game items sold. This surely is a positive for Zynga, as it no longer needs to pay the 30% share. Moreover, Zynga may concentrate more on offering games on its own website or other platforms.

However, Zynga would lose its preferential status on Facebook. It would have to abide by Facebook’s general terms and conditions that are applicable for all other game developers and contributors.

Facebook too will now have the choice of developing its own games and will therefore, be less dependent on Zynga. Though Facebook would be losing out on the 30% revenue share from Zynga, we believe that the company’s huge subscriber base might entice other social game makers to collaborate and sell in-game items through Facebook.

We believe that Facebook has significant growth opportunities from increasing online advertising spending on mobile devices as compared to traditional formats. Facebook’s massive user base and its ability to track personal details over time make it a formidable force in the online ad market. Facebook can use this massive database to help advertisers target relevant ads going forward.

As for Zynga, we believe that it is well positioned to grow in the near term based on its innovative product pipeline and dominant position in the social and mobile gaming sector. Moreover, shareholder-friendly initiatives such as the buyback and cost reduction programs will drive the stock in the near term.

However, the sluggish macroeconomic environment and higher operating costs remain headwinds for both the companies going forward. The lack of visibility around mobile monetization and significant competition from Google (GOOG) in the display ad market are additional headwinds for Facebook.

We also note that barriers to entry are low in the social gaming market and this will attract new entrants, thereby further increasing competition for Zynga over the long term.

Currently, Facebook has a Zacks Rank #2 (Buy), and Zynga has a Zacks Rank #3 (Hold).